Dividend investors prepare for fiscal cliff

The president and lawmakers are in talks to try and avoid the fiscal cliff. Investors in dividend-paying stocks could get hit by higher tax rates if politicians can't come to a deal.

As negotiations over the fiscal cliff get underway in Washington, investors who crave the safety of blue chip stocks are bracing for big changes in how dividends are taxed.

Under the automatic tax hikes and spending cuts that could go into effect January 1, the qualified dividend rate would more than double for those in the highest income tax bracket. Dividends are currently taxed at a rate of 15%.

Yet the prospect of a higher tax rate has not diminished the appeal of dividend-paying stocks for many investors.

"I really don't see any change in the argument that you have to come back eventually to high quality dividend-paying stocks that have the ability to raise their dividends over time," said Ben Fischer, managing director and portfolio manager at Allianz Global Investors.

Most experts believe President Obama and Republicans in Congress will come up with a solution to what everyone agrees would be an economic disaster. But even if taxes on dividend payments go up, many investors expect companies to continue using record amounts of cash to reward shareholders. American firms have an estimated $1 trillion in cash sitting on corporate balance sheets.

The key is to invest in companies that have the most potential to grow dividend payments over time, said Kate Warne, chief investment strategist with Edward Jones.

The sweet spot appears to be a dividend yield between 3% and 5%.

Anything below 3% would not be enough to keep up with taxes and inflation, while stocks that already pay dividends above 5% have less room to increase their dividends. And since yields are a function of the company's annual dividend divided by its stock price, an unusually high yield could actually be a sign of a company in trouble. Yields can go up simply because the stock price is going down.

"There's nothing in the fiscal cliff that says avoid buying dividend-paying stocks, just be a little more careful about which ones you buy," said Warne.

Another reason investors aren't panicking: The higher tax rate on dividends would not apply to retirement accounts, which hold about half of the dividend-paying stocks on the market, said Bernard Kavanagh, vice president of portfolio management for St. Louis-based broker Stifel Nicolaus.

What's more, dividend-paying stocks are really the only game in town for investors who want a steady stream of income, given the meager rates on U.S. Treasuries. Investors have been on the hunt for alternative sources of yield. This has driven up demand for stocks that typically pay dividends, such as utilities, real estate investment trusts and limited partnerships.

"When you look at yields on fixed-income," said Kavanagh. "Where else are you going to go?"

While valuations on some of these stocks have become rich, there are still plenty of reasons to own dividend-paying stocks, said Paul Magnuson, managing director at NFJ Investment Group.

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Magnuson said dividend-paying stocks are an important part of the total return on an investment portfolio over time. They hold up better in down markets, tend to be less volatile and are a measure of quality, he added.

"These attributes are not going to go away anytime soon," said Magnuson.

Still, the higher tax rate could be a problem for those who own dividend-paying stocks that aren't in a retirement account, such as high net worth individuals and hedge funds.

Joseph Perry, a partner at accounting and advisory firm Marcum LLP, said companies could help shareholders avoid the higher tax rate by issuing a special dividend payable before year-end.

In fact, a number of companies have already announced special dividends in recent weeks, including casino operator Wynn Resorts(WYNN), U-haul parent Amerco(UHAL) and asset manager Waddell & Reed(UMUHX).

Perry also recommends stock dividends, which are issued in the form of shares rather than cash.

"A stock dividend is generally not taxed until the stock is sold," he said. "So investors can defer taxes until they sell their shares."

In addition to being able to defer taxes, investors that hold the stock for more than a year would be taxed at the lower capital gains rate if they decide to sell their shares, said Perry.

Nike(NKE) recently announced plans to issue a 100% stock dividend to long-term shareholders as part of a two-for-one stock split. The company did not specify that the move was in response to taxes, but said it remains committed to delivering value to shareholders.